Peace For All

September 21, 2010

The commoditization of the Smartphone Market

Filed under: technology — Devlin Bentley @ 10:43 am

(Note:  I am no longer an employee of Microsoft nor am I in any way at presently related to either Windows Phone or Windows Mobile.  All opinions expressed here are mine and mine alone.)

A Nokia Executive recently said that phone manufacturers using Android is “Like peeing in your pants to stay warm.”  The implication there being that over the long-term the manufacturers are just hurting themselves.

He is correct.

In the long-term, using Android or Windows Phone is a doomed strategy for the phone manufacturers.  The executives of these companies (HTC, Motorola) know this, but they really have no other choice.

For many years now Microsoft has been trying to repeat their successful desktop business strategy in the smartphone market.  As a quick refresher, their desktop strategy was quite simple: 

  1. Make a highly usable desirable OS, licence it to computer OEMs to sell with their machines.  This means all computers sold by different manufacturers will be, to a large extent, identical underneath the lable.  Minor HW differences aside, consumers will desire a “Windows” computer. 
  2. Competition between manufacturers will drive down price, thereby increasing the number of people who can afford to buy a computer, encouraging more manufacturers to enter the market, further driving down prices.  Rinse, wash, repeat, after about two decades an entry-level computer now costs $200.

If you are an OEM though, there is a nasty side effect: The profit margin on a new computer is almost $0.  On lower priced machines those annoying sponsored apps that come pre-installed are often the only way companies like Dell and HP make a profit at all.

Initially things weren’t so bad.  Companies such as Dell and HP had a healthy profit margin.  It was when the first round of drastic price cuts hit in around 1999 that you saw companies like Gateway[1] pretty much cannibalize themselves to stay alive.

Microsoft has been trying to apply this same strategy to the smartphone market for nearly a decade now.  When the smartphone OEMs looked at what happened to Dell and Gateway, and then looked at Microsoft’s offer to take Windows Mobile to the masses, they basically said “no thanks”.   OEMs put the minimal effort needed into selling Windows Mobile to business customers and they never dedicated the resources to it that Microsoft was hoping they would.  After Palm’s initial dropping out of the smartphone market, OEMs stopped competing at all.  Hardware, prices, screen size, resolution, all stayed the same for years. This pleased the OEMs, Smartphones stayed a niche high margin market, being bought by businesses and tech enthusiasts.  Eventually an excuse for the static growth of the Smartphone market appeared: “Consumers do not want to buy smartphones”. Eventually both the OEMs and many within Microsoft started to believe in this excuse.

Apple changed all of that.  Apple demonstrated that you can sell Smartphones to everyday consumers, and pretty much mint money in the process. On some of the earlier iPhones Apple was making over $200 profit per phone sold.  That type of profit margin on technology is just insane.

What happened next was predictable. Everybody starting ramping up Smartphone manufacturing.  Unlike Apple, they are using commodity OSes, either Android, or Windows Phone.

And now they are all doomed.

Right now smartphone OEMs are competing on features.  Resolution, processor speed, memory, storage, camera resolution, screen quality, are all increasing while prices are staying the same.  Phone OEMs are desperate for new features to add to justify keeping prices up, just look at all the buzz about dual core ARM processors that are “coming soon”.  But no matter how hard the OEMs struggle, prices will begin to fall as features level off. 

And the history of the PC market will finally repeat itself.

Microsoft has been working towards this for years.  You have a bunch of really smart people who see the potential of technology, and they have been trying to get that technology out to the masses for over a decade now.  Apple demonstrated that the market is there, Google came along with a shinier OS that is popular right now, but no matter which company ends up winning the mobile handset OS race the overall lesson is that history is going to repeat itself. Prices are going to drop, and OEMs are going to have smaller and smaller margins on handsets.

The phone OEMs know this.  They don’t want it to happen.  The smarter executives see the writing on the wall and are making money off it while they can, the foolish ones may actually believe the current state of affairs (having a profit margin to speak of) is going to last.  It won’t. 

As for Apple?

After a brief flare of massive profitability they will once again fade to being a niche player.  History repeats itself.  They cannot maintain their insane profit margins for much longer, once features level off Android and Windows Phones are going to start to drive down the average cost of smartphones. Apple will either have to lower their prices to compete or once again become relegated to being a high-class luxury brand.

[1] In the mid 1990s Gateway had a reputation for having the best customer service, something I can personally attest to.  My $2000 Gateway computer came with in-house tech support, when something broke a tech guy came and swapped the broken part out. When the price cuts hit Gateway pretty much destroyed their customer service reputation, it has taken them many years to rebuild it.

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